November 3, 2008 by creddy.

Impact of Tight Credit Markets on Business Sale Transactions

“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” - Warren Buffett 

Until about a year back, life in the mid-market M&A lane was somewhat predictable. Most companies entering the deal making process had respectable growth rates, rosy outlooks, and credit was plentiful. Private Equity Groups and lenders had access to money they could put to use on the right deal. More often than not, the sticking point in the deal was the valuation.

All that changed in the last year. As we approach the end of 2008, most businesses are finding that the environment has changed dramatically. A business owner looking to sell is typically in a situation where the trailing 12 month numbers look less than attractive, business outlook is no longer rosy, and credit is extremely tight. The view for the acquirer is not much better. Valuation is not the biggest sticking point any more. Even if the acquirers think they have negotiated an excellent bargain, financing the acquisition is highly problematic.

By some estimates, the value of business deals year to date has dropped by about 35% in spite of a large volume of unexpected distress deals. Excluding the distress sales, total transaction values appear to have plummeted by as much as 50%. In appears that one out two business sale transactions is not materializing largely due to the liquidity crisis.

Unfortunately, the end is not in sight. In spite of the intervention of the government in the recent past, credit is unlikely to be plentiful for the foreseeable future. Optimistic forecasts call for business trends and transaction dynamics to remain unfavorable until the second half of 2009. So, how can sellers and acquirers facilitate a meaningful business sale transaction in the interim?

The answer, while not the most optimal, is surprisingly simple! If lack of liquidity is the problem, then providing or facilitating liquidity is the solution. There are several ways in which sellers can provide or facilitate liquidity in a business sale transaction:

1.    Structuring the deal to reduce third party debt in the deal: This can be done by increasing the money required upfront, taking part of the transaction amount in the deal as earn-outs, retaining part of the equity post-acquisition, increasing the payout time on deferred monies, and other mechanisms that defer the payment schedules. Due to the inherent risks of this approach, extreme care should be taken in inking the terms of such a deal.

2.    Separating asset types for hybrid financing: This can be done by separating asset types (real estate, inventories, receivables, etc.) and finding an optimum way to finance each of the elements. For example, the real estate component could be done in a separate lease-buyback transaction or inventories could be financed by creative lender financing.

3.    Seller financing: While it is not possible in every instance, to the extent possible, sellers can float the required credit to the acquirer. The biggest disadvantage of this approach is that the acquirer’s failure in operating the business can result in a dramatically reduced return to the seller.

4.    Seller loan guarantees: Liquidity can also be facilitated by sellers guaranteeing third party debt in the deal. This approach could potentially reduce the seller’s liability substantially compared to the previous scenario but otherwise is similar in many ways.

With these deal structures, the seller’s vested interest in the deal, post-acquisition, increases dramatically. The biggest risk in any of these approaches is that the acquirer’s ability to make payments will depend on the future success of the business. The acquirer may mismanage the company, or the economic conditions may become more unfavorable, or some other unanticipated event could dramatically reduce the acquirer’s ability to pay down the obligations. Sellers should be cognizant of the risks in these approaches and take precautions to mitigate the risk and improve the return.

On the upside, there are some significant benefits to the sellers. Empirical data indicates that if a seller can assist in financing the deal, the deal value can improve as much as 40%! The deferred payment stream could also result in substantial tax benefits to the seller. Another major advantage of this approach is that the sellers would very likely be able to negotiate a higher rate of return on the deferred payments than the returns available to them elsewhere.

In spite of the sellers’ preferences, sellers should also be aware that, in these tough economic times, acquirers and lenders prefer these deal structures and some may even require them.

From a seller’s perspective, proceeding down this path should be done carefully with enormous attention being paid to the caliber of the acquirers, deal terms, collateral support for the payments, and possibly backup insurance facilities to further mitigate the risk.

Posted in Exit Planning, M&A, Valuation, Deal Structure, Finance | No Comments »

June 12, 2008 by creddy.

Pitfalls To Watch For In Professional Practice Mergers & Acquisitions

Empirical evidence suggests that many small to midsized professional practices are increasingly disintegrating into solo practices or getting merged into or acquired by larger professional practices. The factors driving this trend are: retiring baby boomer practice owners, burned out owners, increased cost of regulation, pervasion of web-based services, and ever increasing infrastructure costs. 

In these uncertain times, middle market practice owners concerned about their financial security need to make some careful choices in deciding which way to go forward. This is especially true for the owners who are close to their retirement. Fortunately, most mid market practice owners have several options: sell the practice, merge with another practice, grow through acquisitions, or continue on the current path and let the chips fall where they may. The latter option is clearly not recommended for practitioners who seek financial security and have the need or desire to feather their nest egg.

If the practitioner is forced by personal issues, familial issues, or does not have the energy or drive to run the practice, a sale of the practice may be the only option. However, merging, reorganizing, or growing through M&A can be desirable paths if the practice ownership has the energy, skills, and sophistication. For the purpose of this article we will refer to the process of merging, reorganizing, or acquiring a practice as a “merger”.

For most practice owners, the biggest benefit of a merger is the size of the combined practice. Increased size can result in several advantages:

Ø  Resources: The resources of the combined organization may allow the practice ownership to attain previously unattainable personal and professional goals or attain them sooner than otherwise would be possible.

Ø  Better Lifestyle: Larger practices afford less administrative overhead for the practitioners while simultaneously providing better coverage for each other with less adverse impact on customer support and retention. A larger practice can help practitioners provide better coverage for the customer without sacrificing personal time-off.

Ø  Customer Leverage: The combined practice can increase the effectiveness of the marketing programs, improve ability to reach customers, expand the range of services that can be offered, and increase the number of touch points to the customer.

Ø  Supplier Leverage: Larger practices typically have more leverage with suppliers resulting in better prices and terms. A larger revenue stream may also enable the practice to attract suppliers unattainable prior to the merger.

Ø  Cost Reduction: Consolidation, with proper planning, leads to more efficient and streamlined use of staff, space, systems, and equipment resulting in lower administrative costs. These cost savings fall to the bottom line and make the practice more profitable and valuable.

Ø  Increased Market Share: Combining practices increases the market share and this by itself can become a virtuous cycle and further propel the practice to newer heights.

Ø  Built-in Exit Strategy: The terms of the combined practice can be written in such a way that there is an automatic exit strategy for an individual practitioner within the group in the event of disability, death or other agreed upon event. If planned well, the outcome for the owner or owner’s estate can be significantly better than what is possible in a smaller practice. 

Ø  Increased Valuation: Practice valuations for mid-market practices vary widely depending on the size, transferability and strategic value of the practice. Transferable, larger practices routinely command EBITDA multiples dramatically higher than smaller practices without a proper management structure.

While these benefits make the M&A path very attractive to practice owners, there are several disadvantages of taking the M&A path and several pitfalls to watch for to arrive at a successful outcome. Here are some concerns and pitfalls and the approaches that can be taken to overcome them.

Ø  Loss of Control: The biggest disadvantage to practice merger is the loss of control and autonomy, real and perceived, by the parties. While the loss of some control is a reality in most mergers, the problems arise when the perceived loss is more acute than expected or when the perceived benefits of the merger are less than expected. In order to minimize the chances of this outcome, ensure that you have a clearly defined buy-sell agreement and an agreement defining roles and responsibilities of the parties post merger. Both these agreements will be of great benefit should the merger not materialize as planned.

Ø  Owner Satisfaction: While successful practice mergers are aplenty, it is not uncommon for owners to be disenchanted with the merged practice. To increase harmony and streamline integration, the goals of the merged practice should be extremely clear and well understood by all parties. What is the purpose of the merger and what is the strategic direction? More services? Broader market? Practitioner coverage?  Going after a different customer base? Whatever the reasons are, if the expectations are clear, the satisfaction of the practitioners and the probability of success of the merged practice is enhanced.

Ø  Capital Structure and Voting Stock: One of the sore aspects of a merger involves lack of agreement on capital structure and control of the practice. A retiring practitioner may care little about control but a lot about the finances. On the other hand, the partner looking to grow may have stronger feelings about control. To avoid this, efforts should be made early on to separate the capital structure from voting rights structure. The financial and governance needs of key management members and the ownership should be addressed and codified. A good set of Bylaws along with delineation between what needs to be approved by board vs. shareholders vs. officers of the company should be well documented.

Ø  Compensation Structure: Compensation structure and division of income for the owners, and key staff members must be developed with an eye toward tax impact as well as fraud and abuse considerations.

Ø  Benefit Plans: A substantial discrepancy between the benefit plans of the merged corporations is another potential problem area in practice mergers. Benefit plans of the merging entities and key individuals must be reviewed carefully and adjusted as needed to ensure there are no post close surprises.

Ø  Compatibility between Practitioners: Practitioner incompatibility is another disadvantage of practice merger/acquisition. This problem can be especially acute if the practice includes several specialty areas and the needs of the specialists are not compatible with the needs of the organization as a whole. Consider this aspect of the merger carefully and put plans in place before the merger to head off any issues.

Ø  Offices & Personnel: Offices & Personnel is another area of friction in practice mergers. Care must be taken to ensure which of the office locations and personnel will continue with the combined practice after the merger. If resolution of this issue is expected to occur post close, bylaws and governance rules can be created to ensure the process for resolution is agreeable to both parties.

Ø  Liability, Fraud & Abuse: Liability, fraud and abuse issues should be addressed to make sure that the combined organization and the key individual needs are adequately addressed. Merging parties typically would indemnify one another from liabilities that predate the merger.

Ø  Supplier & Customer Contracts: Ensure the supplier/customer contracts are reviewed carefully and any differences between two different contracts with the same supplier or customer are reconciled to the advantage of the joint organization (costs, reimbursements, etc.).

Practice mergers can be of great benefit to mid market practice owners. However, practice owners need to be cognizant that practice M&A can be complex and the results can be adverse unless considerable amount of preparation and deal making occur prior to the finalization of the agreement. Extreme care should be taken to ensure that issues such as the ones mentioned above are carefully considered and addressed prior to close. To adequately address these and other complex issues, practice M&A can take an extended period of time. Six to eighteen months of preparation/negotiating from signing of the LOI to the close is common.

The time and money spent upfront to avoid typical merger pitfalls and achieve a common understanding of the deal can go a long way in ensuring the personal and financial goals of the M&A process are realized as planned.

Posted in Business Sucession Planning, Exit Planning, M&A, Valuation, Finance | No Comments »

May 9, 2008 by creddy.

Business Succession Planning Fundamentals

“Dream as if you’ll live forever, live as if you’ll die today.” - James Dean

For every business owner the day will come when it is time for him/her to move on. The reason for the departure may be old age, health, disability, familial changes, burnout, or any number of other reasons. Business succession planning involves planning for a smooth transition of the business in the event of the owner’s voluntary or involuntary departure.  The impact of business planning goes well beyond the survival/transfer of the business and extends to the financial and emotional well being of the owner, his/her family, and the employees of the business. To be effective, business succession planning should start preferably three years before the anticipated date of the business owner’s exit. For most mid-market business owners, their business is the largest component of their estate. In spite of this reality, most business owners do not find business succession planning to be a priority. They stay busy with mundane operation issues and neglect succession planning until it is too late.  The result of the lapse can be catastrophic. Empirical data suggests that less than a third of family businesses survive the first generation of business ownership. Only a tenth of the businesses make it past the second generation. These statistics would likely be significantly better if the owners did business succession planning. By reading this article, you are already a step ahead of a typical business owner. No business owner who cares for his estate or his employees should ignore the business planning process. To ensure financial security, and to properly transfer the wealth to the next generation, business succession planning must be a part of the estate planning process. The first step in business succession planning is to understand the end goals of the overall estate planning process. The goals, for most owners, are financial security, transferring the wealth to the next generation, continuing the family legacy, etc. In translating these goals into business succession planning, the owner is faced with several possible scenarios:

There is a single potential successor: In this scenario the business owner needs to determine if the successor is ready, willing, and able to take over the reins of the business. Increasingly, the potential successor, typically a son or daughter, has interests that differ substantially from the business owner’s.

In some cases, even a capable and able successor may not have the motivation and drive necessary to take over the business and make it flourish. The business owner needs to contemplate if a transition to this successor will result in the desired financial and other outcomes. If the business owner suspects that the estate’s goals are not likely to be met with the transition, then (s)he needs to determine if it makes sense to recapitalize the business or sell the business and transfer the proceeds to the estate.

There are multiple potential successors: It may sound logical to split the business among the successors and give them different roles in the company (some roles could be operational and others could be non-operational). Empirically, a business with multiple owners tends to wither away as each stakeholder pulls it in a different direction. It is common for multiple successors to be embroiled in a power struggle that tears the company apart and negatively affects the interests of the family, the estate, and the employees.

The other common problem with multiple successors is that the successors who end up becoming active owners will very likely end up getting a dramatically larger share of the benefits of the company at the expense of the non-active owners.  Unfair distribution of wealth and the violation of rights of minority shareholders is a common theme in many family business transitions. Given these realities, multiple successors pose a particularly difficult choice for a business owner. The owner needs to seriously consider how the business may be run by multiple successors in his/her absence and see what steps can be taken to arrive at an equitable and harmonious transition that preserves the will of the estate. If the owner wants any semblance of equity and harmony in such a situation, advice from a competent business succession planning expert is mandatory early in the process. If a fair and cordial resolution is unlikely or unsustainable, the owner and the heirs’ interests may be better served by selling the business and distributing the proceeds to the heirs.There are no likely successors: If there is no potential successor that could run the business, the choice is clear and the best value for the business can be attained by a recapitalization or a planned sale.

Regardless of which scenario the business owner finds himself/herself in, the planning process should begin early so that proper arrangements and precautions can be taken to maximize the value of the business. The outcome of the business succession planning should include a clear understanding of the goals, the process to achieve the goals, and contingencies in case of unexpected developments.

Posted in Business Sucession Planning, Exit Planning | No Comments »

April 29, 2008 by creddy.

The Horror of C-Corp Asset Sale

“I’m proud of paying taxes. The only thing is–I could be just as proud for half the money.” – Arthur Godfrey 

We recently completed the sale of a healthcare deal where the seller had his business incorporated as a C-Corporation. When we informed him of the downside of a C-Corp in a asset sale, the business owner was stunned. While C-Corp business sale has no disadvantages when it comes to a stock sale, the tax burden on the asset sale of a C-Corp can be onerous to a business owner.

To begin with, C-Corp shareholders suffer from double taxation. All corporate income is taxed at the corporate level and any distributions of the profits to shareholders in the form of dividends are taxed at the shareholders personal level. For most mid-market businesses in California, the gains at the corporate level are taxed at the corporate tax rate of 42.84% (34% federal and 8.84% CA State). Further compounding the problem is the fact that there is no such thing as Capital Gains for C-Corps. All income, including income on properties held on a long term basis, is taxed at the same rate.

Assuming an asset sale, which is the preferred type of sale for most acquirers, and worst case allocations, the seller is looking at a potential tax liability of 42.84% at the corporate level and a further 44.3% tax liability at the personal level (35% Federal and 9.3% CA State) leaving him with an effective tax rate of about 68% of the gains on the transaction price! Ouch!!

The worst case scenario for an S-Corp asset sale is far superior. The seller only needs to pay 1.5% at the Corporate level (0% Federal and 1.5% CA State) and a further 44.3% at the personal level. The difference in sale proceeds from a C-Corp and an S-Corp amounts to 22% of the gains in this worst case allocation scenario. On a $10M transaction gain, that boils down to $2.2M!

This above scenario is the worst case and with more reasonable allocations and with some creativity in deal making, this difference can be narrowed significantly. However, even in highly optimistic allocation scenarios, sellers are looking at about a 15% difference in take home just because they chose a wrong corporate structure!

In the case of our healthcare business owner, we could locate a buyer who was willing to do a stock sale and we were able to put together a dramatically better deal for the seller with a 24.3% tax bite (15% Federal Capital Gains Tax and 9.3% CA State). That’s about a 44% savings on taxes compared to the worst case asset sale scenario! We were pleased with how well we could serve this client, but not all stories end so well.

If you are a business owner with a C-Corp, here are some options to help avoid the nightmare at exit:

1.    Unless there is a compelling reason to remain as a C-Corp, switch to an S-Corp. Note that there is a 10 year recapture period before the conversion is complete. Consult your CPA or M&A advisor for advice on steps that you need to take if you plan to sell the business within the 10 year window.

2.    Consider moving or retaining the ownership of all appreciating assets outside of the C-Corp into a different entity such as an S-Corp or an LLC.

3.    For all future incorporations, avoid a C-Corp structure altogether unless there is a very compelling reason to be a C-Corp (ex: having plans to go public or having a lot of shareholders).

4.    If you have a C-Corp, for all practical purposes, you must aim for a stock sale. Look for an M&A advisor who has the proper licensing and experience in doing stock deals. Anecdotally, about 1% of the small to mid-market business intermediaries have the proper licenses to do stock sales. Surprisingly, most business intermediaries are unaware of the licensing requirements required in stock transactions.

Unfortunately, for the business owner, if an unlicensed intermediary does a stock deal, the acquirer may be able to rescind the transaction for up to 3 years after the close of escrow per the provisions of Section 29 of Securities Exchange Act of 1934. Yet another nightmare scenario! For Information about licensing requirements and the SEC act of 1934, see:

http://www.law.uc.edu/CCL/34Act/sec29.html  http://www.californiachronicle.com/articles/52091

Tax laws are complex and change constantly. This article is only intended to provide an insight into some of the major implications of choosing a particular corporate structure. Contact your CPA for tax advice. For information about the specific tax bracket you are in, see: http://www.smbiz.com/sbrl001.html  

Posted in Exit Planning, M&A, Tax Related | No Comments »

April 29, 2008 by creddy.

10 Step Plan To Exiting A Mid-Market Distribution Business

“He who fails to plan, plans to fail” – An old proverb 

You have worked hard for many years to build your distribution business. It has provided you income, satisfaction, prestige and purpose. Now is the time to do one final deal on the business and exit your business while making sure that that you get what you deserve.

A mid-market distribution business, the type of business you have, is typically characterized by strong customer relationships, good logistics and material management system, moderate amount of equipment, and sometimes a large amount of inventory. This combination of assets creates a unique set of challenges when it is time to sell.

Here is a 10-step plan to maximizing your return on the sale of your mid-market distribution business.

1.    Be aware that for a distribution company with a valuation in the $3 million to $100 million range, funding from the Small Business Administration is not feasible and there are very few individual buyers capable of financing this type of deal on personal credit. The most likely acquirer is another private company, a public company, or a PEG (see “Is Private Equity The Right Option For Your Business”). These are professional buyers who have experience from multiple deals. Hire a competent M&A advisor or an investment banker to bring deal making experience to the table. Acquirers think in terms of multiples of EBITDA for comparable companies when it comes to valuation. A good M&A specialist will help increase the EBITDA, ratchet up the multiple, and expose the strategic value of the business to get you more for your business. An M&A Advisor will also be keenly familiar with the tradeoffs necessary to maximize your after tax proceeds.

2.    Check if your corporate structure is the appropriate one for a business sale. Are you a C-Corp? S-Corp? LLC? Do you have multiple entities with multiple purposes? Regardless of the type of corporation(s) you have, if your distribution company has a large amount of depreciated assets, depreciation recapture may be a big issue for you. For distribution companies with a substantial amount of assets, being a C-Corp can be a major tax disadvantage as most acquirers prefer an asset sale to a stock sale. In a C-Corp asset sale you get taxed twice – once at the company level and once at the individual level! For most distribution company owners, it is worth getting your M&A advisor to fight for a stock sale.

3.    Make sure your books are in order and your financial statements are compiled, reviewed or audited as may be appropriate for your business. Your current bookkeeping practices and tax structure may be designed to keep your taxes low on an operating basis but they may not be right for exiting your business (see “What Every Business Owner Needs To Know About Taxes & Valuation”). If your CPA firm does not have any deal making experience, consider working with a firm that has the experience. In mid-market transactions, good tax advice may be worth hundreds of thousands, if not millions, of dollars.

4.    Retain the right attorney for the deal. An attorney with transactional experience as opposed to litigation experience is more likely to help put together a successful deal. Many deals collapse due to attorneys who are not familiar with transaction negotiations.

5.    Understand how your competition is performing and how you measure up. How good are your profit margins? How about inventory turns? Is your equipment outdated? Do you have a lot of dead inventory on the books? Some of the value in the deal comes from the acquirer’s perception of how you rate in your peer group. Excellent companies get excellent valuations and mediocre companies get mediocre valuations. A competent M&A advisor can also help package your company to get the best deal out of it.

6.    Reduce risk by diversifying the customer and supplier base. What percent of your business is tied to one customer? How dependent are you on one supplier? What can you do to ensure the customers and suppliers will continue to stay with the business after the business sale? Are your contracts being written so that they can stay with the business regardless of ownership changes?

7.    Understand and have a documented plan for your growth. How do you plan to grow? Wider product lines? More services? Increasing geographic coverage? What part of your business is online? How good is your website? Do you do business outside of the immediate geographic area? What differentiates you in non-local markets? A good growth plan makes sales projections more credible.

8.    Take steps to ensure that your distribution business transitions easily to the acquirer. What percent of your business is under contracts? Are they long term? How much of your business is recurring? Do you have any maintenance contracts? Do any of the supplier contracts provide meaningful exclusivity? Do you have a reliable sales team or do the customer relationships begin and end with you?

9.    Do you have any known latent liabilities? Legal actions? Workers comp issues? ESOP issues? Do you have reasonable insurance coverage or you exposed to that one shipment or warehouse catching fire and taking you down with it? If possible address these and other similar issues before putting the business up for sale. If not, discuss these with your M&A advisor to make sure that they do not become a drag on valuation or deal killers. Addressing these issues is especially important if you are seeking a tax advantageous stock sale.

10. Be cognizant of the fact that business valuations are not written in stone and there is a huge variability in what you can get for your business (see “The Myth Of Fair Business Valuation”). The more you would like to get for your business, the more planning and work your deal making team needs to do and the longer it is likely to take. Plan early if you want to maximize your return.

Good luck with your business sale and let us know if we can help you.

Posted in Exit Planning, M&A, Miscellaneous, Finance | No Comments »